How High Oil Prices Lead to Recession

There is ample evidence that spikes in oil prices leads to recession, at least in the US, which is an oil-importing nation. James Hamilton has shown that 10 out of the last 11 US recessions were associated with oil price spikes. How does this happen? An analogy can perhaps help explain the situation. This analogy also sheds light on a number of related economic mysteries:

How can oil have a far greater impact on the world economy than its share of the world GDP would suggest? After all, BP’s World Energy Outlook to 2030 shows the world cost of oil is only a little over 4% of world GDP.

How can high oil prices continue to act as a “drag” on the economy, long after the initial spike is past?

Why isn’t a service economy insulated from the problems of high oil prices? After all, its energy use is relatively low.

The Oil Analogy

An oil product, such as jet fuel, is in some ways analogous to a specialized employee, with skills different from what human employees have. Let’s think of an airline. It has human employees–pilots, copilots, flight attendants, baggage workers, mechanics, and airport check-in personnel. None of these human employees can actually provide the energy to make the jet fly, however. It takes jet fuel to do that.

What happens if the price of jet fuel triples? Jet fuel is now more that than triple the price (near $3.00 gallon) it was in the late 1990s (under $1.00 gallon, at today’s prices).

Figure 1. Jet fuel price in December 2012 $. Jet fuel price per gallon is Spot Gulf Coast price from EIA; price adjustment based on CPI-Urban, from US Bureau of Labor Statistics.

The high cost of jet fuel is analogous to the jet fuel employees’ union demanding triple the wages they were paid previously. So what is the airline to do? With very high aviation fuel prices, many tourists who might buy airline tickets will be “priced out” of the market for long distance travel. The airline can sell some airline tickets at higher prices, but not as many.

One thing airlines can do is to cut the number of flights, taking the least fuel-efficient planes out of service and reducing flights on routes with the most unfilled seats. According to a recent Wall Street Journal article, airlines spend 34% of revenue on fuel. With such a high fuel cost, even with these changes, airline ticket prices will remain high. But perhaps with fewer flights, the airline can make a profit.

If an airline cuts its number of flight, this leads to an “across the board” cut in the goods and services the airline buys. The airline will use less jet fuel (and thus use fewer “jet fuel employees”). If it is able to retire quite a few fuel-inefficient jets, “jet fuel employees” will be cut to a greater extent than human employees. It will use fewer human workers, at all levels: pilots, copilots, flight attendants, and ground workers of all types. The airline will reduce its electricity usage because it needs fewer gates in airports for its operations. The airline will also need less gasoline because it will operate fewer baggage-transport vehicles and other ground vehicles.

In many ways, the airline is simply shrinking in size to reflect reduced demand for its high-priced services. When this happens in multiple industries, the result looks very much like recession. I described this situation earlier in a post called How is an oil shortage like a missing cup of flour?. In that post, I said that if oil supplies are short, the situation is not too different from a baker who does not have enough flour to make a full batch of cookies. If he still wants to make cookies, he needs to make a smaller batch, and so needs to cut back on all of the other ingredients as well.

Other Changes an Airline Can Make to Fix Profitability

Apart from cutting back on the number of flights and retiring inefficient jets in the process, there are other things an airline can do to offset the higher “wages” demanded by the jet fuel employees union. One is to reduce the wages of human workers. For example, wages and pension plans of pilots can be cut back, or hours lengthened. Wages of other workers can be frozen or cut back.

Another approach is a merger with another airline, so that “redundant” employees can be eliminated, and flights can perhaps be cut back further. Of course, these layoffs and cutbacks in wages will add to recessionary impacts, because these workers will have less discretionary income.

A third approach to restoring profitability is to automate some of the functions previously handled by human employees. In this case, electricity is used to substitute for human workers. We can think of this automation as substituting new “electrical employees” (analogous to the “jet fuel employees”) for human employees. Relative to the amount of physical work (pushing buttons, moving luggage, etc.) humans can do, humans are far higher paid than either “oil employees” or “electricity employees”. If we assume that the energy of humans is similar to that used by a 100 watt light bulb, at $20,000 a year, humans are paid roughly 1,500 times as much as “oil employees” and 3,500 times as much as “electricity” employees, to do equivalent physical work. So if automation is an option, it almost always saves money.

A fourth way an airline can reduce costs is by purchasing lighter, more fuel-efficient jets. Making a transition of this type takes a long time. Boeing’s Dreamliner 787 is an attempt in this direction, with a 20% fuel savings anticipated. Boeing has over 800 jets of this type on order, but the 50 already in use have been grounded until battery problems are resolved. Quite a few changes have been made in the new jet, so there is a possibility of additional problems also needing to be ironed out, before production ramps up as planned.

Another Example: Asphalt

Asphalt is another product whose consumption has dropped in recent years.

Figure 2. Trends in US Fuel Consumption by Type, with 1994 = 1.0, based on EIA data.

The amount of asphalt produced in 2012 was only about 70% as much as was produced in 1994. The reason for the shortfall in asphalt is partly because at current high oil prices, refineries can make more profit by selling high-valued products like gasoline, diesel, and jet fuel than they can make by selling asphalt. A recent EIA article titled, Hydrocracking is an important source of diesel and jet fuel, makes the statement, “A refinery’s ability to upgrade low-value products into high-value products and convert high-sulfur material to low-sulfur material with a secondary unit like a hydrocracker plays a key role in determining its economic fate.”

State budgets are tight for a variety of reasons, including inadequate gasoline taxes to cover the cost of maintaining roads. While part of the need for asphalt can be obtained from recycling, many governments are finding that today’s asphalt costs are so high that concrete roads would be cheaper in the long run. Many states have found it necessary to go back to gravel on some of the smaller roads, because of the high cost of paving today. State and local budgets are likely to be stretched even farther if the US government solves its budget woes by sending programs back to the states, and lets the states work out the funding.

What happens when a state decides move some roads from asphalt back to gravel? For one thing, jobs lost in the road paving business. Also, the new gravel roads have an uneven surface, providing more rolling resistance, so automobile and truck mileage is poorer. In addition, roads tend to degrade more quickly, keeping long-term maintenance costs high. If budgets are tight and roads are not maintained, there is a chance gravel roads will become unusable.

If local governments continue to use asphalt for paving (or switch to concrete, which has even higher initial costs, but lasts longer), they find a need to cut back on other types of services they provide, if they are to avoid a tax increase. This leads to services such as library hours being cut. Cutting back on services reduces both wages and energy costs (lighting and heating/cooling costs). The effect is not all that different from what happens in the airline industry: cuts are made that affect both wages and energy usage of many types. Employee wages seem to be especially affected because changes in employee hours can be made more easily than, say, closing a building or running fewer school buses.

The More General Problem

It is not just airlines and users of asphalt that cut back because of high oil prices. The story plays out in different ways in many industries. Clearly any restaurant is at risk if high oil prices cause consumers to cut back on discretionary purchases, because reducing the frequency of eating out is an easy way of reducing discretionary expenditures. If restaurants have fewer customers, some restaurants will close and are not replaced. This is the restaurant industry’s way of “making a smaller batch”. The result is fewer jobs, less oil use, and less use of resources in general.

Another type of discretionary purchase that gets cut when oil prices are high is the purchase of a new car. A recent article by the New York Times says that the recovery of auto sales since the recent recession has been very slow, with charts for several countries. Reduced car sales is yet another example of making a “smaller batch.” The result is fewer jobs, less use of oil, and less use of many other types of resources.

A similar story can be told about new home sales. These dropped in the recent recession, and have been slow to recover. The drop-off is frequently attributed to the housing bubble bursting, but rising oil prices played an important role as well. When oil prices increased in the 2004-2005 period, the Federal Reserve raised interest rates, trying to cut oil prices. Instead, the higher interest rates together with lower discretionary income from high oil prices led to lower housing prices, starting in 2006. (See my article from the journal Energy, here or here.)

The Economic Implications of High Oil Prices

Our economy is all about “adding value”. But where does this value added come from? To a significant extent, this value comes from adding external energy of some sort. It is really the “energy employees” I mentioned earlier that add this value. Human workers are needed as well, but with automation, the number of human workers required tends to decline.

The ability of external energy to add value is what causes the link between GDP, energy consumption, and oil consumption. Oil plays a special role, because it is easily transported, and can be used in many situation where electricity or some other form of energy (such as human energy, wind energy, or natural gas) would not work.

If we look at a graph of changes GDP compared to changes in world oil and energy usage, (Figure 3, below), we see that all three tend to rise and fall together. In fact, changes in oil and energy usage appear to slightly precede GDP changes. This is the pattern we would expect, if economics are causing a “smaller batch” to be made when oil prices are high.

Figure 3. World growth in energy use, oil use, and GDP (three-year averages). Oil and energy use based on BP’s 2012 Statistical Review of World Energy. GDP growth based on USDA Economic Research data.

Part of this change may simply reflect a transfer of energy use from less efficient industries (ones using more high-priced oil in their fuel mix) to more efficient industries (ones using less high-priced oil in their fuel mix). If could also reflect a shift in oil and energy distribution to more less efficient countries (ones using more high-priced oil in their fuel mix) to more efficient countries (ones using less high-priced oil in their fuel mix). For example, Greece (which specializes in vacation tourism, and which uses much oil in its energy mix) would be expected to be an oil/energy loser (Figure 4, below).

Figure 4. Greece’s growth in energy use, oil use, and GDP (three-year averages). Oil and energy use based on BP’s 2012 Statistical Review of World Energy. GDP growth based on USDA Economic Research data.

Figure 5. China’s growth in energy use, oil use, and GDP (three-year averages). Oil and energy use based on BP’s 2012 Statistical Review of World Energy. GDP growth based on USDA Economic Research data.

High prices work together with a number of other factors (including increased automation and increased competition from countries with lower wages) to force wages of humans down, and to reduce the number with jobs. The proportion of US citizens with jobs started declining about the year 2000 and accelerated with the recent recession:

Figure 6. US Number Employed / Population, where US Number Employed is Total Non_Farm Workers from Current Employment Statistics of the Bureau of Labor Statistics and Population is US Resident Population from the US Census. 2012 is partial year estimate.

If we look at the ratio of wages (broadly defined, including proprietors’ income and taxes paid on behalf of employees by employers, but not including transfer payments, such as Social Security payments and Unemployment Insurance) to GDP in Figure 7, below, we see that the ratio of wages to GDP has been dropping since 2000–another indication that human wages are not keeping up with the rest of the economy.

Figure 7. Wage Base (defined as the sum of “Wage and Salary Disbursements” plus “Employer Contributions for Social Insurance” plus “Proprietors’ Income” from Table 2.1. Personal Income and its Distribution) as Percentage of GDP, based on US Bureau of Economic Analysis data. *2012 amounts estimated based on part-year data.

If “Energy Employees” Are Really Doing Most of the Work

If it is really the “energy employees” doing most of the work, then the models used by many economists today are not really correct, and some of the standard beliefs based on these model aren’t right either. For example:

1. The idea that the value of oil or other energy to the economy is proportional to its price doesn’t hold. This can be seen from the examples provided. In fact, if oil or another needed energy product is removed, very close to no work gets done. Humans can provide a little energy, but compared to the energy of oil or electricity, our efforts are puny, and very high-priced. Without external energy, humans’ efforts are limited to tasks like digging with a stick in the ground, or making baskets with reeds that they have gathered.

2. One type of energy doesn’t necessarily substitute easily for another type of energy. Just as one type of employee (mechanic, airline pilot, or flight attendant) can’t necessarily be substituted for another, one type of energy cannot necessarily be substituted for another. Dreamliner’s battery problems illustrate that even trying to substitute a little more electrical energy for oil energy can provide a technological challenge.

3. Somewhat surprisingly, high oil prices remain a drag on the economy permanently, because the high wages of the “oil employees” remain. Output isn’t any higher with these higher wages, so there is not a proportional benefit to society from these higher oil wages. More human workers may be hired in the oil extraction process (often in another country). But even if more workers are hired in the same country, their output does not replace the entirely different kind of output that is provided by the (now-unaffordable to many) high-priced oil.

Another factor in the slow uptake of high oil prices is the fact that governments can temporarily hide some of the effects of high-priced oil through unemployment benefits and stimulus programs. This temporary cover-up cannot continue for long, though, because governments (such as the US and other oil importers) soon run into problems with high deficits (as is happening now). When governments raise taxes or reduce benefits to solve their financial problems, the deferred high-priced oil problems return, showing that the problem never really left.

4. An economy which is mostly services, is not insulated from the problem of high oil prices. Both the airline and asphalt examples illustrate how high oil costs can circulate through the economy and disrupt discretionary spending, even in the US. (Also see Ten Reasons Why High Oil Prices are a Problem.)

Services tend to be the “fluff” of society because for the most part, because we could live without them, at least temporarily. For now, we have a temporary respite from oil-price impacts because of high deficit spending by governments. If governments are forced to balance their budgets, cutbacks seem likely in many areas of services, including medicine for the elderly, higher education, and government-sponsored research programs. If cutbacks occur in areas such as these, we can expect that GDP will shrink faster than savings in oil and energy use–a reversal of what has happened in the past, and a reversal of what many economists have come to expect in the future.

Also, contrary to popular belief, we cannot increase the economy very much by simply selling services that do not require energy to one another. It really takes “energy employees” to play their role as well. Without external energy, we can dig in each others’ back yards with sticks, but this activity doesn’t add much to the economy. We need “energy employees” playing their role as well, if we are to have computers, and metal scissors, and the many other tools we expect, even in a service economy.